Wednesday, December 19, 2012

The so-called developed economies
remain in a low nominal growth
environment where the private sector deleveraging and the over-indebtedness
of the public sector act as structural growth headwinds. Historically, the
public sector successfully deleveraged via default or via a long-lasting
combination of relatively tight fiscal
policy (to slowly move to a primary surplus) with an ultra-loose monetary policy (to get low/negative real yields,
accompanied by other elements of financial repression). Between 2010 to late
2011 the handling of the Eurozone debt crisis (ultra-tight fiscal policy
& limited support from monetary policy, Greek PSI) increased the
probability of the default option and hence meant high and rising systemic
risks. However, in 2012 governments and more importantly the ECB changed the
trajectory via the introduction of OMTs (whereby the ECB has assumed the
lender-of-last-resort role for governments), the start of the ESM and steps
towards a banking union as well as a weakening political support for ever more
fiscal austerity. In turn, the Eurozone has been moving towards the second
option for debt reduction, substantially reducing
systemic risks.

Moreover, also policy makers in the
UK and US have been moving towards a tighter fiscal but looser monetary policy
stance. Finally, following two years of ever weakening growth, the global
economy is in a bottoming process and real growth should increase moderately
going forward, lead by an improvement in Asia ex Japan. On the other side, amid
the ongoing deleveraging and the high level of unused capacity, inflation
pressures in general remain low and hence nominal growth should remain low as
well.

Eurozone real growth should slowly bottom out and move slightly above 1%
in H2 2013. Germany should lead the
rebound on the back of increased export demand and as record low real rates as
well as rising immigration support the domestic economy. Moreover, Italy might be surprising with a growth
pick-up. On the other side, due to the ongoing substantial fiscal tightening,
France and Spain should lag in this recovery. Overall, the necessary
rebalancing of the Eurozone economies should take a major step forward. While
real growth should improve, inflation
pressures will drop further. Roughly half of the current core inflation
rate of 1.4% stems from the effects of the restrictive fiscal environment. As
the impact of fiscal tightening slowly wears off, inflation rates should fall. Furthermore,
excess capacity remains at very high levels, preventing inflation from rising
even if growth improves. As a result, nominal
growth will remain low for a long time. Global real growth is in a bottoming process and should improve
gradually during 2013. The outlook for inflation is mixed, with falling
inflation pressures in the Eurozone and gradually rising core inflation
pressures in the US while Japanese deflation can abate if the BOJ goes down the
proposed policy route. Furthermore, systemic risks should remain at the now
lower levels. This is an environment where risk appetite can improve,
safe-haven assets should come increasingly under pressure, assets linked to
real growth will be supported but assets linked to inflation should face a
mixed outlook. Importantly, it will mainly be the safe-haven currencies central
banks (BOJ & FED, BOE) which will provide an increasing dose of
monetary accommodation. This should undermine the safe-haven status of their
currencies exactly at a time where risk appetite improves.

Long carry products with a focus on steep curve areas. Move outright longs in
higher-yielding semi-cores into spread trades vs. Bunds. Outright longs in
peripheral bonds and spread tighteners vs. Bunds across the curve. Start
the year with Bund shorts spread trades and add outright shorts as the
year progresses.

There are three key
points I want to make which I think so far have gone
underrepresented:

1. Inflation
pressures in the Eurozone are highly overstated. I adjust the
Eurozone inflation figures for the effects of restrictive fiscal policy (via
higher prices for administered goods and higher taxes on consumer goods). This
adjusted core measure runs only at around 0.5% yoy! Hence inflation for the
private domestic economy is almost non-existing. I think this is so far not
really recognized but should come as no surprise given the high level of unused
capacity/record high unemployment and the subdued development of monetary
aggregates and loan growth (loans to non-financial corporates have been falling
by 1.8% in October yoy). As "true" inflation is lower, "true" real yields are
somewhat higher than those traded in the market (which also focus on HICP) and
hence the safety premia inherent in Bunds is lower. I do expect Bund yields to
rise over the medium term as real growth improves and the stress in peripheral
bond markets eases, however, nominal growth will remain subdued and hence upward
potential for 10y Bunds is limited (I expect 1.75% 6m).

2. Markets have
shifted their trading behaviour. Ever since the financial crisis broke out, RORO
(risk-on, risk-off) dominated market developments. Equities, credit spreads,
volatility, commodities, growth currencies have all moved in sync and opposite
to safe-haven assets (Bunds, UST, JPY, USD). RORO was dominated by changing
perceptions of systemic risks (which then drove also the expectations for growth
and inflation). Now, however, systemic risks have been dropping significantly
(as the ECB has turned itself into the lender-of-last resort for sovereigns) and
RORO has given way to GOGO (growth-on vs. growth-off). In this environment it is
changes for nominal growth which drives market performance while systemic risks
remain low. In turn, equities, commodities and growth currencies move in sync
while credit spreads and volatility remain low even during periods where the
other markets correct.

3. In an environment
of limited volatility and anchored short end rates (as central bank target rates
remain unchanged), so-called Horizon Returns gain in importance as a tool to
direct investment/as a relative value tool. It is not only carry that is
important but also roll-down on the yield curves. Horizon Returns measure both.

My investment views
remain unchanged: Systemic risks remain low favouring carry products. The
long-term trend towards lower nominal yields on safe products is over (i.e. Bund
yields most likely have hit bottom) but upside potential on safe yields is
moderate in the short term. The long-term trend towards lower nominal yields on
carry products is not over (and hence semi-core/peripheral bonds have more
potential). The global growth cycle should have bottomed with Asia ex Japan
improving and the slow improvement of the US economy only being temporarily
interrupted by the fiscal cliff. Growth currencies should be bought and
safe-haven currencies should be sold on uptics (with the Euro being between
these two groups).

Wednesday, November 7, 2012

Amid the zero rate policy of the ECB, its significant balance sheet lengthening with the help of the 3y LTROs as well as the introduction of Outright Monetary Transactions (should a country apply for help of the ESM) some commentators (especially in Germany) fear that the ECB has become too tolerant of higher inflation and see inflation pressures as being just around the corner. Currently, Eurozone headline HICP stands at 2.6% yoy and core inflation at 1.5%. Amid the weak state of the economy this would at first sight confirm that inflation might become a serious issue once growth starts to recover. However, this is largely due to tighter fiscal policy and as I will show below domestic inflation pressures in the core countries are limited and the periphery is even flirting with deflation. Given that at present private sector loans in the Eurozone are collapsing (the annual growth rate of loans to non-financial corporations stood at -1.4% in September, down from -0,7% in August) and unused capacity is substantial, domestically generated inflation does not promise to become too high within the next few years even with a zero rate policy by the ECB for much longer.

The chart below shows the development of various Eurozone HICP inflation measures. Headline HICP is currently running above target (blue) while core HICP (black) of 1.5% is close to the ECB's target of "close to but below 2%". However, amid the widespread fiscal tightening - especially in the periphery - prices for administered goods and services as well as taxes such as VAT have gone up and hence have a strong impact on current inflation rates. I calculate a core HICP measure excluding administered prices (red) which is currently running at only 1.0% (just one caveat: the basket of administered goods and services as well as the basket of energy and food might partially overlap and hence it is not a perfect measure but just an estimate). Hence, 0.5% of current inflation is due to changes in prices of administered goods and services. Furthermore, I used Eurostats constant taxes inflation measures to also deduct tax changes from the inflation rates. This core HICP CT ex admin prices inflation rate currently stands at only 0.7% (green, this series is only available with a one-month delay). Hence, another 0.3% of current inflation are due to tax changes.
As a result, at present approx. 0.8% out of the 1.5% core inflation rate are due to fiscal tightening! The real domestic inflation rate currently stands at a much lower 0.7% and does not show any meaningful risk of rising inflation pressures. Clearly, the ECB should c.p. rather ease monetary policy in an environment of tighter fiscal policy even if the tighter fiscal policy temporarily leads to a higher measured HICP.

Eurozone inflation rates

Source: Eurostat, ResearchAhead

In the chart below I show the core HICP measures for the four largest Eurozone countries (Germany, France, Italy and Spain). Looking at this measure one would conclude that inflation rates are close to each other and close to target. Furthermore, Spanish inflation has risen significantly over the past months.

Country core HICP

Source: Eurostat

However, looking at the core HICP CT ex admin prices for these countries leads to very different conclusions: A) inflation rates between the core and the periphery have started to diverge significantly (this should be seen as a positive factor as it helps the Eurozone to rebalance). B) Spain and to a lesser extent Italy are flirting with deflation.

Country core HICP CT ex admin prices

Source: Eurostat, ResearchAhead

Overall, inflation pressures in the Eurozone are low. However, the risks of deflation in the periphery are significant. In this environment, the ECB can conduct more monetary easing without threatening price stability. Amid the high level of unused capacity, significant fiscal tightening and very restrictive monetary environment in the periphery (high level of real yields, low credit availability) a renationalisation of monetary policy seems very sensible. The sooner the ECB eases the monetary environment in the peripheral countries (for example via buying peripheral debt), the better.

Thursday, October 18, 2012

The first phase in the recovery of financial markets started at the end of July when ECB president Draghi delivered his London speech where he effectively pre-announced the buying programme for peripheral bonds ("To the extent that the size of these sovereign premia hampers the functioning of the monetary policy transmission channel,
they come within our mandate. So we have to cope with this financial fragmentation
addressing these issues.”). This transferred the ECB in a de-facto lender-of-last-resort for Eurozone sovereigns. As a result, the tail risks of a Eurozone break-up/a wave of sovereign and bank defaults have been reduced drastically. Amid lower systemic risks, spreads on carry products including peripheral bonds tightened, equity markets recovered and safe-haven yields (Bunds) went into range-trading mode while the Euro recovered against almost any other currency. Over the past weeks, however, markets went into consolidation mode amid still weak economic data and doubts about the effectiveness of monetary policy. Now, however, this consolidation is over and markets are entering a second phase of recovery.

10y Spain-Bund spread: Long-term tighteing trend since Draghis's London speech intact, temporary consolidation period now over

Source: Bloomberg

While the first phase was driven by lower systemic risks, this second phase should be driven by an improving growth environment as well as by ongoing easy monetary conditions. I have been expecting US growth to recover starting with data referring to September. Reasons are that the longer-term underlying fundamentals have been improving amid a stabilisation in the housing market, a much reduced household debt burden and the restoration of the monetary transmission channel. Seasonal adjustments are still playing havoc with the released data though and seasonally adjusted data paint too weak a picture during spring and summer. However, from September onwards this reverses and seasonally adjusted data paints more or less an accurate picture (September/October) to a too strong picture (from November onwards). Hence, the positive data surprises should continue. Furthermore, the Asian economies seem to be stabilising as indicated by the export data for September from Korea, Taiwan and also China. Finally, in the Eurozone sentiment data has been bottoming out and should improve further, followed by a return to moderate growth (I expect 0,5-1% growth in early 2013). On the other side, inflation has mainly been driven by commodity prices and in the Eurozone also by higher taxes/higher administered prices (amid fiscal tightening) and the core numbers ex administered prices are low (smaller than 1% in the Eurozone). Hence, there are no inflation risks present. In combination with the major economies operating significantly below potential, the major central banks do not need to take any tightening steps for a long time.
This combination of a high level of excess liquidity, no threat from inflation/tighter monetary policy coupled with improving growth should support risky assets over the next months and credit spreads should tighten further. In the periphery, long-end spreads have the most tightening potential (So far I preferred the 4-7y area in Spain/Italy and would now focus on 10y instead). The debt-deflation spiral (higher yields leading to a worsening in the long-term debt dynamics, more fiscal tightening, weaker bank balance sheets and a weaker economy and amid higher credit risks leading also to higher yields) has been broken and the risk of a buyers' strike has been much reduced. In turn, yields can fall significantly further. On the other side, Bund yields should bear-steepen moderately. The recovery in the Euro has further to run. However, while the first phase in the recovery was marked by a general appreciation of the Euro against almost any other currency, from now onwards the recovery should be mainly against former "safe-haven" currencies (such as the USD or the JPY) whereas growth currencies (from commodity producers/emerging markets) should start to fare better again.

Tuesday, September 25, 2012

I have previously stated that with the introduction of Outright Monetary Transactions (OMTs) the ECB has become the de-facto lender of last resort for Eurozone sovereigns. Before that it was only the lender of last resort for Eurozone banks and did everything to keep solvent banks liquid. Now it also keeps solvent sovereigns liquid and in the eyes of the ECB the solvability of the sovereigns will be assured via the conditionality of an ESM programme. Hence, solvent sovereigns cannot become illiquid anymore and a devastating bank-sovereign default spiral has become a much less likely event.
However, one can also look at the OMTs as providing the ECB with a targeted instrument to conduct a national monetary policy during a period of a renationalisation in financial markets.
Within the Eurozone, financial markets have disintegrated along national lines over the past years. Banks in the core have significantly reduced their holdings of peripheral assets and so did real money investors. On the other side, peripheral banks have increased holdings of domestic sovereign bonds.
Furthermore, the level of monetary accommodation is extremely different depending on the country one is question. The chart below shows the level of yields in Germany and in Spain.

ECB repo rate, Spain & German yields

Source: Bank of Spain, Bloomberg

Hence, the debt crisis has meant that the Eurozone has lost control over the level of yields in the periphery. While the monetary accommodation in Germany increased with every rate cut, the debt crisis led to an ever tighter monetary environment in the periphery. The result of very high yields coupled with a deep recession was that loan growth collapsed.

Yoy loan growth in Spain and Germany

Source: ECB

Prohibitively high yields and significantly negative loan growth mean that the monetary environment in Spain is extremely restrictive while it should have a very accommodative environment. on the other side, Germany with record low yields and moderate but positive loan growth enjoys an accommodative environment. More rate cuts would do not help Spain where monetary accommodation is needed but Germany where it is not. However, OMTs - once Spain or Italy decide to apply for help - will be helping to ease the monetary environment (to be more precise: render it less restrictive) where it is needed most without providing more accommodation where it is not needed.

Hence, the ECB has a tool provide a national monetary policy. While not exactly in the spirit of a monetary union, it will help to ease the burden of adjustment. Furthermore, given that it is a targeted form of monetary policy to be provided where it is needed most, the inflationary risks should be limited. However, it significantly reduces the likelihood that the ECB will continue to provide general monetary easing via another cut in the deposit rate into negative territory.

Friday, September 14, 2012

Besides being the lender-of-last-resort for banks, the ECB will from now on also assume the lender-of-last-resort role for sovereigns. As mentioned previously, this reduces tail-risks significantly. The EFSF/ESM will keep sovereigns solvent and the ECB will keep these solvent sovereigns liquid. Hence, the risk of Spain/Italy etc. becoming illiquid has vanished. Furthermore, given that nominal yields on peripheral debts are falling, the long-term debt dynamics are improving significantly as well. The result is that it does not really matter whether the ECB is "only" active at the short end and the risk of investing into longer-term peripheral securities has been falling markedly.
Additionally, the US Fed has made significant steps as well. Not only is it starting another round of quantitative easing, it has gone even further by stating that: "If the outlook for the labor market does not improve substantially, the
Committee will continue its purchases of agency mortgage-backed
securities, undertake additional asset purchases, and employ its other
policy tools as appropriate until such improvement is achieved in a
context of price stability… A highly accommodative stance of monetary
policy will remain appropriate for a considerable time after the
economic recovery strengthens."
Hence, the FOMC is orchestrating an open-ended liquidity glut and promises to keep it going even once the economy is on a stronger footing again. I also agree with Lars Christensen (see here for his excellent Blog: The Market Monetarist) that this constitutes very positive news and while not exactly nominal GDP targeting, it is a significant step in the right direction.
The effects of this combination of the ECB removing significant tail-risk to the Eurozone economy and the US Federal Reserve providing an open-ended USD glut should not be underestimated. I am convinced that sentiment towards the Eurozone economy can improve with the current mild recession giving way to a low growth environment (below trend amid the fiscal tightening but positive growth nonetheless) over the next few months. Additionally, seasonal adjustments still play havoc with US economic data but now as we are entering autumn the drag from this factor (which depresses seasonally adjusted data during spring and summer) reverses and we should get better economic news over the next weeks. Hence, the environment should remain very positive for risky assets. Lower tail-risks, a stabilisation in the Eurozone economy and better data out of the US coupled with more liquidity should see an ongoing buy-on-dips environment. I am not particularly concerned with respect to the timing risk of Spain (and Italy) applying for help from the EFSF/ESM. This is a much different kind of risk than the fundamental risks of a debt-deflation spiral/Eurozone break up which we were facing before and should not cause more than some temporary volatility.

The Euro can recover further as the short-squeeze carries on whereas the USD should get under broad-based pressure (hence EURUSD should move higher). Commodity, pick-up & emerging market currencies should start to be supported again by the USD glut.

Credit spreads have much further to fall and credit spread curves should flatten. The trend towards record low nominal yields on carry products is not over.

Hence, while during the first phase of financial easing being long duration and long credit was fine, now being short duration and long credit makes more sense.

Wednesday, September 12, 2012

I am convinced that negative real yields are a phenomenon which will spread to an increasing number of assets and which will be with us for the rest of this decade. I have suggested earlier on (see "Life in a negative real yield environment" dated August 21) that negative real yields not only provide an easy
monetary environment but that they also help to lower debt-GDP ratios over
time. Contrary to popular opinion, high inflation rates are not a
necessary condition to lower debt-GDP ratios. As long as deflation is
averted, ultra-low nominal bond yields provide for the necessary
low/negative real yields.
In the Eurozone, the ECB first pushed real yields on Germany Bunds into negative territory via cutting the repo/depo rates to record lows. Thereafter, with the help of the LTROs announced last December, it was successful in driving real yields on the so-called semi-core markets (Netherlands, Finland, France, Austria, Belgium) into negative territory. Finally, with the help of the announced Outright Monetary Transactions it aims to do the same for peripheral bond yields (and I think they will be successful).

Negative real yields have frequently been used in history to lower debt-GDP ratios over a time horizon of about a decade (see "The Liquidation of Government Debt" by Reinhart and Sbrancia, NBER Working Paper 16893, March 2011 - thanks to Peter Schaffrik for directing me to this paper). To quote:
"Throughout history, debt/GDP ratios have been reduced by (i) economic growth; (ii) a substantive fiscal adjustment/austerity plans; (iii) explicit default or restructuring of private and/or public debt; (iv) a sudden surprise burst in inflation; and (v) a steady dosage of financial repression that is accompanied by an equally steady dosage of inflation."
In the current environment, higher growth is difficult to achieve amid the need to bring down budget deficits, the low rate of trend growth in Western countries and increasing headwinds from demographic developments. Austerity programmes work only in the medium-to-longer term and initially kill off growth and hence can even raise indebtedness. Default/restructuring has frequently been used in the case of foreign currency debt (because there was no other option left) which is not the issue in the Eurozone at present. I do not expect a surprise burst in inflation given the ongoing deleveraging (which limits the availability of credit in the broad economy and hence is deflationary) and the high amount of spare capacity/high level of unemployment. I have been of the opinion that we will see a slow reduction in debt-GDP ratios on the back of very low nominal yields, moderate but positive inflation and hence negative real yields. This is exactly the point Reinhart/Sbrancia make as well: "We find that financial repression in combination with inflation played an important role in reducing debts. Inflation need not take market participants entirely by surprise and, in effect, it need not be very high (by historic standards). In effect, financial repression via controlled interest rates, directed credit and persistent, positive inflation rates is still an effective way of reducing domestic government debts in the world’s second largest economy-- China."

The reduction in real yields has been the key factor driving nominal yields lower

Source: St. Louis Federal Reserve

Reinhart/Sbrancia attribute negative real yields almost exclusively to financial repression on the back of explicit or indirect caps or ceilings on interest rates as well as the creation and maintenance of a captive domestic audience that facilitates directed credit to the government. At present, however, I think we have only a mild form of financial repression at work (short-end yields are set at or close to 0% by central banks), rather I see some additional reasons why longer-term real yields have dropped so sharply since 2009 (see chart): Given that longer-term growth expectations have dropped markedly and demand for capital is weak amid the ongoing deleveraging/low level of investment, the risk-free "neutral" longer-term real yield has come down significantly compared to the time period leading up to the financial crisis. Moreover, central banks have started bond-buying programmes (quantitative easing) to directly lower bond yields and have provided a very high amount of liquidity to the banking sector (which the banks at least partially used to buy sovereign bonds) which also resulted in lower bond yields. The latter is clearly not a traditional "repression" tool which would rather see banks being forced to buy government bonds via changes in regulations rather than incentivise them to enter carry trades at free will via the provision of unlimited quantities of liquidity.
Hence, so far the "repression" element needed to bring real yields into negative territory appears softer than in the past. However, given that ultra-low/negative real yields are needed for a long time (10 years) to bring down debt-GDP ratios significantly, I think that at a later stage (i.e. in 3-5 years), stronger "repression" elements will become a distinct possibility in order to maintain the ultra-low real yield environment.

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About Me

Daniel was Head of Economics & Strategy for developed markets at Dresdner Kleinwort until early 2009 and was responsible for the well-known 'Ahead of the Curve' flagship publication. He started as a Desk Analyst in the mid-90s for the former German government bond trading desk. He then became Head of Rates Strategy early last decade and later on also took responsibility for G10 economics, commodities strategy and asset allocation.
He is now the owner of Research Ahead GmbH located in Frankfurt am Main.

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